Monday, February 22, 2010

The Tyranny of the Tangible

As human beings, we enter life with a natural bias towards the tangible, those things that we can see, feel, hear, or touch.  Furthermore, those of us trained as engineers, scientists, mathematicians, accountants, economists, or financial analysts have an almost holy reverence for data especially the numerical kind.  "Show me the numbers!" we cry.

Naturally, this bias carries over to the startup world, particularly if the entrepreneur comes from one of the aforementioned disciplines.

So?  What's wrong with that?

Nothing, provided that we remember that much of the value inherent in a startup lies in the intangibles; intangibles like inspiration, creativity, employee morale, ethics, customer loyalty, brand awareness, energy, boldness, and vision.  What is the value of a creative environment?  How does one measure the ROI of employee morale? How does one assess the impact of workplace energy?

People have tried and continue to try quantifying intangibles with satisfaction surveys, brand unaided recall percentages, and customer retention indices. But even these are difficult to tie to the financial bottom line. At best, the intangible's metric is statistically correlated to some revenue, expense, or asset measure, but it's still squishy, lacking the firm certainty of a hard expense like wages.

One of the few places financial accounting1 and intangible value cross is when a company is sold and a mysterious item called goodwill appears on the balance sheet of the acquiring company.  What is goodwill?  It's the excess of the purchase price over the net tangible assets of the acquired company.  This gap represents the intangible value created by the acquired company. In the case of an initial public offering (IPO), the intangible value usually shows up as additional paid in capital which is the cash the company receives from the sale of its stock in excess of par value.

If you don't think this is significant, let's take a look at Google.  On June 30, 2004 just prior to their IPO, Google had a net assets of $589 million.  On September 30, 2004 shortly after the August 14th IPO, Google's net assets were $2,589 million due mainly to an increase in additional paid in capital of $1,540 million.  In other words, investors paid over 2-1/2 times what Google's pre-IPO net assets were worth!  And goodwill?  Well Google is an acquirer of startups as well.  As of December 31, 2009 the goodwill on Google's balance sheet stood at $4.9 billion.

So am I saying that we should ignore the numbers in running our businesses?  Of course not.  (Anyone who's ever worked with me can attest to my penchant for metrics.)  But given the human bias towards the tangible, it is up to the entrepreneur to make sure that the intangibles are not marginalized by what's been called the tyranny of the tangible and that it receives a proper weighting in decisions that affect the long term value of a company.  Small wonder that in recent years, the elevator pitch, which rarely contains distracting numbers, has become such a prevalent sorting tool by many VCs.

Here are three tips for tempering the tyranny of the tangible:
  • Beware of false precision - Beware of decimal points.  Just because the number popping out of the sales forecast spreadsheet says $1.5427 million, does not mean that it is so.  How precise were the numbers going in?  Are you sure this isn't more like $1.5 +/- $0.5 million?
  • Know the limits of your financial models - Closely related to the above.  Linking your total available market and customer acquisition estimates into your revenue model does not make them more precise2.  Models are useful for understanding dependencies and possibly variable sensitivities.  But don't expect a +/-5% sales figure derived from input variables with a +/-25% uncertainty.
  • Temper the numbers with common sense - Do the numbers seem surprising?  Maybe they need a closer look.  But how do you do this when you have no idea what a surprising number looks like?  This is where business can be more of an art than science, where experience, intuition, and a dose of common sense come into play, and often what separates the successful from the unsuccessful entrepreneurs.
With respect to this last bullet, let me recount a story from my college days:

As a chemical engineering undergraduate at MIT, I was required to take a class in heat and mass transfer.  One of the exams required us to calculate the time it would take to cook a strand of spaghetti.  Of course, we had been armed with all the appropriate equations, knew the simplifying assumptions, and were given the relevant dimensions.

I don't recall whether I got the answer right but what I do still remember was the post-test review.  Here, the professor informed us that student answers to the spaghetti problem ranged from less than 1 microsecond to over 1000 hours!

He then proceeded to pull out an exam book (not mine) and read what the test taker had written at the bottom after pages and pages of scratched out calculations.  To paraphrase3:

"Dear Professor.  I've obviously made a mistake in my calculations because it shows the spaghetti taking 100 milliseconds to cook.  Now I know that's wrong because spaghetti takes at least 5-10 minutes to cook...."

The student received an A.

  1. For all you accountants out there, yes I am aware of the fact that I 'm grossly oversimplifying things. 
  2. For all you statisticians and investment analysts, yes, I'm also aware of Modern Portfolio Theory, Harry Markowitz, and the concept of co-variance which I'd argue rarely applies here. More applicable here is the old programmer's rule of GIGO ("garbage in, garbage out"). 
  3. Sorry, I just can't recall the exact wording after 25 years.

No comments:

Post a Comment